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A radical new option for the financial rescue of Cyprus would force losses on uninsured depositors in Cypriot banks, as well as investors in the country’s sovereign bonds, according to a confidential memorandum prepared ahead of Monday’s meeting of eurozone finance ministers.

The proposal for a “bail-in” of investors and depositors, and drastic shrinking of the Cypriot banking sector, is one of three options put forward as alternatives to a full-scale bailout. The ministers are trying to agree a rescue plan by March, to follow the presidential elections in Cyprus later this month.

The new plan has not been endorsed by its authors in the European Commission or by individual eurozone members. The memo warns that “the risks associated with this option are significant”, including a renewed danger of contagion in eurozone financial markets, and premature collapse in the Cypriot banking sector.

It would reduce Cyprus’s outstanding debt to just 77 per cent of economic output, compared with 140 per cent in the current full bailout plan.

Labelled “strictly confidential” and distributed to eurozone officials last week, the memo says the radical version of the plan – including a “haircut” of 50 per cent on sovereign bonds – would shrink the Cypriot financial sector, now nearly eight times larger than the island’s economy, by about one-third by 2015.

But the authors warn such drastic action could restart contagion in eurozone financial markets, and put forward two more cautious alternatives.

Curious Thing About That "Full Bailout"

Notice how the existing "Full Bailout" still leaves Cyprus with a debt-to-GDP ratio of 140%. To get to an also unsustainable ratio of 77% requires a radical new plan.

Of course when that fails as well, there will be still more radical plans.

This morning hot topic has been a Financial Times article: Radical rescue proposed for Cyprus which indicates that depositors as well as investors in the country sovereign bonds stand to lose up to 2/3.
Cyprus is in need of approximately 17 bln. EUR - and how to reduce the overall burden which will reach 140 percent by 2015 without a hair-cut.- EU Finance minister meets tonight and need to secure deal before March 1st, 2013.

These are the leaked three options on the table:

Bail-in (the radical version) - Reducing outstanding debt to 75-ish percent via hair-cut which will hit foreign depositors and bond holders. This will hard on the big investor Russia.

Bail-in (Light version) - Only junior debt holders will be hurt, not bank depositors - this would however prolong the reduction of the banking sector by ten years - the suggestion will include increase corporate tax from 10.0% to 12.5% and withholding tax on capital income to 28%

A classic ESM structure - selling the 'nationalized' Cypriot banks to the ESM and secure funding. Problem being ESM is not allowed, yet, to do direct funding of banks.

The political decision is really down to how big a reduction Cyprus need. Some people argues for 100 percent by end of 2015, others say it should be by 2020.

The deep irony of course being, that when we had the hair-cut on Greece, we were told Greece was a one-off and it will never be repeated - Well, Dr. Watson, It's elementary: Other people money is always easy to spend.

Cyprus is seen by many countries as tax heaven for Russian money, so bailing out Cyprus equates to "helping Russia investors" - We have no view on the issue but note how Asmussen, ECB Board member, is taking the high road in German press: ECB's Asmussen sees Cyprus bailout by end-March.

Conclusion

It's clearly a concern for market that Greece was not, after all, a one-off. The radical version could reignite fundamentals issue in Europe and as we have written in our Stress Indicators recently: Risk off looks more and more likely.

We suggest securing profit and to reduce overall risk- mainly in EUR, JPY and major European indices. The deal will probably only be done at last minute, but it leaves us "hanging" for another two-three weeks, and one thing the market does not like is increased political tail-risk.

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management. He writes a global economics blog which has commentary 5-7 times a week. He also writes for the Daily Reckoning, Whiskey & Gunpowder, and has over 80 magazine and book cover credits. Visit http://www.sitkapacific.com